Investing

ETF’s: Diversification Reduces Risk, But Kills Competition

Where ETF's are great instruments for investors seeking for diversification, common ownership has its drawbacks. In this article we dive deeper in the common ownership trilemma and why common ownership could be bad for our economy.

Since big players like Vanguard and BlackRock introduced exchange traded funds (ETF’s), investors have been able to effectively reduce risk in their portfolios. However, this has created a market externality that comes at the cost of the overall economy and might dis-incentivize firms to compete with each other. ETF’s contribute to common ownership of companies, and their boards are effectively only serving the interest of their shareholders by trying to gain as much capital as possible for them, creating a distorted business model on the long run. As many ETF’s are industry and sector specific some competing firms will come under the watch of the same shareholders whose interest is not always in-line with what is best of the company. These companies will be less inclined to compete with each other if the opposing competitor has the same owner.

Silent Cartel-Forming Can Harm Consumers

If all companies across the industry will have the goal to serve the common owner, this can lead to silent cartel forming, where there is no need for specific agreements to offset anti-competitive behavioral practices. This can vary from limiting production and the raise of prices, but also more in-evident measures like reduced investment which leads to lower innovation. Where in mergers there are clear regulations in place to prevent the creation of monopolies, common ownership is harder to map, analyze and therefore harder to regulate. In many different countries new policies are set in place to improve transparency related to ownership. In the European Union the Ultimate Beneficial Owner (UBO) register has been adopted and impelemented to map all shareholders with over 25% ownership within a certain firm. Under the 5th Anti-Money Laundering Directive the register has been mandated to be open to the public.

Empirical Evidence Is Ambiguous

Koch et al. (2021) do not find a robust relation between common ownership and industry-wide price-levels, nor do they find evidence for industry profitability. However, their results could differ if tested for higher percentage levels of common ownership. Moreover, we know that there are anti-competitive effects from common ownership in the airline and banking industries (Azar et al., 2016; Azar et al., 2018). However, it is clear that common ownership has its effects on the market and therefore could be prone to regulation if competition authorities find more robust relationships. Three index fund manager effectively control the whole index market, Vanguard has 51%, BlackRock 21% and State Street Global 9%. The large jump below in 2010 is due to the acquisition of Barclays Global Investment by BlackRock in 2010. This shows that the rise of common ownership of large blocks of stock is to a large extent a consequence of the rise of index funds and of what Azar (2020) calls “the Big Three”.

Figure 1 – Common Shareholder Pairs S&P 500 (Azar, 2020)

The Common Ownership Trilemma

But it all comes down to the classic common ownership trilemma in which portfolio diversification, shareholder representation and competition are balanced. The most extreme scenario being a situation where all companies within a certain sector have to same common owner, that is when both shareholder representation (of the common owner) and portfolio diversification are maximized, but effectively create a monopoly in which there is no place for competition. There is a wide gap between some common ownership and monopoly-like destruction of competition, but the drawbacks of common ownership should be faced as it the whole of society benefits from healthy competition driving market dynamics leading to technological innovations and ultimately economic growth. Moreover, it could be argued that shareholders on the long run benefit more from competition and the resulting innovation as competition does not have to be a zero-sum game. When discounting for future profits, shareholders could actually be better off in a situation with high levels of competition, therefore competition authorities have every incentive to keep protecting healthy dynamics within the market.

In conclusion, it is good that regulators start implementing policies that map the common ownership. Tackling the potential negative sides of the drive for diversification in the financial sector will be much harder, as investors and thus large stakeholders in this debate have deep pockets which will potentially undermine the effectiveness of every policy set in place to reduce negative externalities involved with high levels of common ownership. For now, it remains to be seen if governments are strong enough to withstand lobbyists.

Bibliography

  1. Koch, A., Panayides, M., & Thomas, S. (2021). Common ownership and competition in product markets. Journal of Financial Economics, 139(1), 109–137. https://doi.org/10.1016/j.jfineco.2020.07.007
  2. Azar, J., 2016. Portfolio diversification, market power, and the theory of the firm. Unpublished working paper. University of Navarra.
  3. Azar, J., Schmalz, M.C. and Tecu, I. (2018), Anticompetitive Effects of Common Ownership. The Journal of Finance, 73: 1513-1565
  4. Azar, J. (2020). The common ownership trilemma. University of Chicago Law Review, 87(2), 263-296.

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